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Financial Romanticism

October 9, 2011 6:27 pmOctober 9, 2011 6:27 pm

One line I’ve been seeing in various places, including comments here, is the claim that the real way to deal with Wall Street is laissez-faire economics: no more bailouts! On this view, policy makers should raise their right hand in the air, place their left hand on a copy of Atlas Shrugged, and swear in the name of A is A that they will never again step in to rescue failing banks. And all will be well with the world.

Sorry, but that’s a fantasy.

First of all, bank regulation is important even in the absence of bailouts. Don’t trust me, trust Adam Smith. Scotland invented modern banking; it also invented modern banking crises; and Smith, having witnessed such a crisis, favored bank regulations, declaring that

Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.

Second, there are in fact very good reasons to intervene to support banks during a financial crisis. Bagehot knew it; Diamond and Dybvig showed it theoretically; and it remains true. Letting a financial crisis spread is very dangerous.

Finally, even if you persuade yourself that the moral hazard created by financial firefighting outweighs the benefits of avoiding a 1931-style cascading crisis, the fact is that policy makers will intervene. Hank Paulson set out to make Lehman an example; two days later he was staring into the abyss.

So the only feasible strategy is guarantees and a financial safety net plus regulation to limit the abuse of those guarantees. It’s imperfect; it faces the constant threat of regulatory capture; but it has worked in the past, and it’s the only game in town.